海角大神

As we all know, the one benefit of paying all of that interest on our mortgages is that it generally creates a tax deduction. And if you have been carrying a mortgage for a good portion of your adult life, you have become accustomed to鈥攁nd plan around鈥攖hat deduction come tax time each year.

In fact, I have listened to multiple clients use the deductibility of interest as a reason for keeping debt, even when they have the means to pay it off and remain financially secure.

Are they right? Let鈥檚 take a look.

First consider the difference between a tax聽deduction聽and a tax聽credit. A tax聽credit聽reduces your tax bill dollar for dollar, whereas a tax聽deduction聽allows only a portion of each dollar paid to be deducted.

Assume you are in the 28 percent tax bracket, and the amount of your deductible interest totals $1,000. (For simplicity, we will assume that the entire amount of interest paid is deductible.) Through a tax credit, your tax bill would be reduced by the entire $1,000. Through a tax deduction, however, your tax bill would decrease by only $280, or 28 percent聽of $1,000. So your $280 tax deduction effectively cost you $720. That鈥檚 better than no deduction at all, but it鈥檚 still far from a good deal.

Now you can certainly 鈥渨in鈥� the tax game if you earn more on your assets than you are paying in interest. Given the past five years of market returns and historically low mortgage rates, this may seem like a no-brainer.

But be careful. Even with low mortgage rates, can we expect a similar鈥攐r even 鈥渁verage鈥濃�攎arket performance? I鈥檓 not sure I would plan on that. Think about it another way: A fixed-rate mortgage provides you with a known amount (principal and interest are predictable) that you are responsible for, but future investment performance is unknown. Planning on that unknown variable to perform well enough to continuously cover that known variable could be disappointing.

Where does this line of thinking originate?

If you are retired and still carry a mortgage, you have obviously included your mortgage payment within your required income amount when planning. But what about a scenario where you have a smaller portfolio but also a lower income requirement?

Most investors do not consider this scenario; they look at income replacement rather than expense coverage.

For most, retirement income needs are fashioned according to how much they are spending now, and that amount includes their mortgage payment, which is likely to be their largest monthly expense as well.聽 This amount gets hardwired into their planning and becomes part of the聽minimum聽monthly income amount needed in retirement.

Behavioral finance teaches us that we have no trouble increasing our standard of living if we are able to, but we don鈥檛 particularly like decreasing our standard of living if we have to. By having this debt payment hardwired into retirement income planning, it leaves the door open to replacing that payment later on with another one.

Does this mean that you should never carry a mortgage or other debt that offers tax benefits? Not at all! Debt that offers tax benefits is definitely better than debt that does not, but the simple fact that your interest is tax deductible is not in itself a reason to carry debt鈥攅specially in retirement. Obviously, directing funds toward paying down debt will likely affect the level of savings and must be considered. However, a retirement income need that excludes debt payments may require a lower level of savings without assuming additional investment risk.

Each individual鈥檚 situation is unique, and some folks will inevitably find it impossible to enter retirement debt free. Others may have significant discretionary income in retirement and aren鈥檛 concerned about eliminating this debt as soon as possible. Still others may enjoy moving every few years into a new home and financing the purchase. However, my experience and education leads me to believe that entering retirement debt free is ideal, both financially and emotionally.